Trivia 2

Trivia question - Does the stock price on the market directly reflect the performance of the company such as increase in the bottom line is because of increase in the stock price? This is with reference to the equity market.

The reason for asking this question is because I was going through an abstract of the press interview of the CFO where it was asked that though the performance of the company was good, the stock was not doing that well. The CFO replied that sharp movements in the stock price had nothing to do with the performance of the company.Rather he was not clear on the reasons for the volatile movements in the stock market.

Also he mentioned that the stock price could be affected because of the recent rights issue for raising funds within the company which could have had an impact.This has resulted in the share capital to be expanded.

If the answer is no, does it mean that the investors are not really making an informed decision on buying or selling stocks such as scrutinizing the balance sheets or income statements or making an analysis of the stock price movements? this should mean that they just speculate on the price of a particular stock to go up or go down and not really bothered about the company's bottom line.

can you let me know your views when you are free?

Ø Well the stock price of any company represents a combination of various factors. What we find as the valuation of a stock on the bourses factors in macro economic, industry/sectoral and company specific events and news flows.

Ø A mix of fundamental and technical analysis is used in arriving at the right valuation for a stock. These are the two main approaches in analyzing the movement of share prices –the fundamental and technical approach. Both the approaches have the objective of buying the share at a lower price and selling it at a higher price.

Ø A fundamental analyst would be concerned with the fundamental factors affecting the industry and the company forming part of that industry like geo political factors, sectoral outlook, past financial performance of the company, earnings outlook for the future, evaluation of the operational metrics like management quality and governance issues,capacity utilization, Production efficiency, inventory management, supply chain management etc… Based on all the above factors the fundamental analyst will arrive at a fair valuation for the company. If the current market price at which the scrip is being traded is lower than the fair value/intrinsic value, the analyst would recommend a buy on the stock and vice versa a sell if the intrinsic value is lower than the current traded value or market price of the stock.

Ø A technical analyst on the other hand is concerned with the direction of the share price movement (trend analysis). He studies the price- volume data of the underlying scrip and takes his directional call on investing in that stock. His approach would be based on the analysis of supply demand situation for particular scrip. If the demand for a scrip is greater than the supply, obviously the prices would move up. A normal investor will enter into the scrip only after the price has risen substantially as price movements in the market can happen within a matter of seconds. Whereas a technical analyst would have spotted this movement in the scrip atleast a couple of weeks earlier than the normal investor and he would have entered the scrip at a much lower price. Even a fundamentally strong stock which has been giving consistent results and has been showing a strong growth pattern will not merit a high at higher price levels. Similarly a company with poor fundamentals and moderate market presence will be a strong buy at lower price levels. But a share analyst or a broker will combine both the methods of fundamental as well as technical analysis to his investing/trading approach. Both these approaches to investing compliment each other quite well. A technical analyst would look at the basic fundamentals before investing and a fundamental analyst would bear in mind the technical position of the market at the time of investing. Usually short term traders trade purely based on news flows and technical analysis. A combination of fundamental and technical analysis usually serves its purpose only for medium to long term investors who have an investing timeframe of not less than 6 months. Technical analysis is a vast complicated subject which encompasses a number of statistical theories and methods for clinical analysis of the stock markets. It identifies trend reversals, enables forecasting of stock prices, identifies overbought-oversold stocks and provides a general indication of the direction of the market for a given time frame.

Ø Now most players in the share market will tell u that the market discounts everything and every bit of news flow, financial information, brand image of the company, insider news, investor expectation, and speculative interest is factored in into the stock prices. Therefore from the market participants’ point of view, the market is always considered to be supreme and all positive and negative views of any company are already taken into account in the traded price or current market price of the stock. I would largely agree with them because speculation in the share market does exist but cannot sustain itself on a longer timeframe. Speculation used to be a major concern in the 80’s and early 90;s before the advent of SEBI when it was possible to get the market rigged through a cartel formation …As u may be knowing Harshad Mehta and Ketan Parekh are standing examples…Now with the information dissemination systems and regulatory mechanisms getting robust, speculation has been largely curtailed and restricted to High Net Worth Individuals(HNI) and hedge funds and such activities are largely seen in illiquid stocks or penny stocks where investor interest is pretty low. It has become increasingly difficult to speculate in Nifty 50, BSE -500, CNX – 500/Midcap related stocks due to continued efforts and the hawkish stance of the market watchman (SEBI)...to give u an example. the very existence of circuit filters came in to being to prevent the price of any particular scrip from rising or falling by more than 20% on any particular day. Investor interest and protection has become a paramount objective of SEBI these days.

Now coming to the case with California Software, my observation is as follows:

Revenues on stand alone inc by 24%,, interest by 250% and employee cost by 45%..PAT margins 18 to 12%, Op margins from 21 to 17

• The CFO is partly right in his observation that the rights issue has affected the share price. From what I have observed the rights issue of this company has been completed in May 06 and the issue price was at Rs.66 (which was a discount to the market price of Rs.82 as on May 06) .Ever since then the share price has shown a decrease to a low of Rs.54 this May and has rebounded to Rs.68 levels as on date. Every rights issue will be seen with a slightly negative bias as the equity base of the company will increase and as a result the EPS is bound to come down. The dilution of the earnings per share will lead to a temporary negative sentiment on that particular scrip. However this may not be the case all the time. For eg ADitya Birla Nuvo came out with a rights issue at around Rs.750 when the share price was trading at 1250 and its still trading at Rs.1300 levels. The share price did not fall after the rights issue. There is a difference in investor perception towards each counter. Aditya birla nuvo is a conglomerate with a presence in various industry verticals like textiles, cement, aluminium & copper, mining, retail etc and each of its verticals have been showing consistent growth with expanding margins. Therefore investors associate a higher premium for such counters due to the earnings growth story. They believe that even on an expanded equity base the company will be able to deliver their return expectations. Therefore the counters where the share prices fall in the long term, post rights issue are the ones where the investors believe that their returns will be diluted due to rise in the equity base.
• Even if we take the case of California software, one can observe that the EPS on a stand alone base has fallen from 13.49 for FY 06 to 7.58 for FY 07. Even assuming that rights issue had not taken place, the EPS would have still been 12, which is a drop below the previous year. Though the company has shown robust growth in the last few years, the following reasons can be attributed for the company’s non performance in the stock market over the last one year:

1.) The negative impact of the rights issue leading to a diluted equity base

2.) The turnover on a stand alone basis has increased by 24% whereas the employee cost has risen by 45% and interest cost has risen by a whopping 250% compared to FY06. Higher interest cost indicates that the balance sheet is highly geared and a high debt equity ratio is always a negative for the stock prices. As a result both the operating margins and PAT margins have been hit drastically with the OPM falling from 21% in FY 06 to 17% in FY 07 and the Pat margins dropping almost by more than 30% from 18% to 12%. Though the company has reported strong growth in its consolidated financials, the stand alone organic growth for the current year has not been impressive from the market’s point of view. Falling margins are a major negative which gets factored in to the stock prices also.

3.) The company has acquired a few companies, launched new products in the last one year and has also entered into Joint venture agreements with various companies abroad. Though these events show promise in the long run as the company is making efforts to expand across its major verticals, the clarity on the funding pattern for these acquisitions, multilayered financial transactions has not yet emerged and the effect of the new launches as to whether they will be revenue accretive and their ability to penetrate into new markets will have to be seen in the long run.

4.) Other factors that are holding the stock down are the general concerns in the IT industry about recession in the US economy and rupee appreciation which will affect the realizations of all exporters and the competitiveness of Indian exports in the global markets.

5.) Though the operational metrics for Calsoft look strong backed by a quality management team, the lack of impressive growth in the stand alone financials during the last one year, fall in dividend rates from 10% to 7.5% on an expanded equity base, falling margins, lack of clarity on international operations and a highly geared balance sheet are concerns that have been factored into the stock prices with a negative bias. The company needs to improve its financials in the long run through certain restructuring efforts on the cost front, as whatever may be the explanation any management might give on the operations and growth plans of an entity, investor’s needs hardcore numbers in the form of a bulging topline, bottom line and returns from holding the scrip.

6.) Frequent investor conferences and meet ups to create awareness and bring out clarity on the domestic and international operations of the company will improve liquidity in the counter. The counter has witnessed very low trading volumes in the last one year explaining the dormancy in its market price.

7.) California Software at the current market price of Rs.68 discounts FY 07 consolidated earnings of Rs.10.29 by around 6.8 times. The share price should move up to 90-100 in the next 6 months supported by reasonable improvement in margins as well as buttressed by the fact that the average trading PE for companies of similar size is in the range of 9 to 10 times trailing FY 07 earnings.

Therefore in my view, based on the above factors the share prices do have an axiomatic relationship with a company’s performance in the medium to longer term time frame.